Taking Tax Advice From Friends

 

I received a text message one night this past week.

I was researching living trusts on the internet. It sounds like it might work for my situation.

I had two immediate reactions:

First, excellent. I am a fan of doing your own research and understanding what an expert is recommending.

Second - and maybe more important – use the expert.

The problem with DIY tax research is that you may not know what you do not know. Granted, in many cases it might not matter as much (hey, can I deduct the mileage for my gig income?), but in other cases it might matter a lot.

Let’s talk about the Horowitz case from 2019.

Peter Horowitz was an anesthesiologist. Susan Horowitz was a PhD working as a public health analyst for the U.S. Department of Health of Human Services.

In 1984 they moved to Saudi Arabia. They lived mostly on Susan’s income while banking most of Peter’s salary.

They used U.S.-based accountants, so they knew to (and filed) federal taxes on their Saudi earnings.

One thing about a bank account in Saudi Arabia: it does not pay interest. After a couple of years, the Horowitzes got tired of that and opened a Swiss bank account. They were also concerned about untangling the Saudi account when the Saudi gig played out.

Makes sense.

The Horowitzes did not tell the U.S accountants about the Swiss account. This meant that they did not report the interest income nor did they report the existence of the foreign account to the Treasury or IRS.

Why?

Their friends in Saudi Arabia told them that they did not have to pay U.S. tax on interest earned on the Swiss account.

In 2001 they moved back to the U.S. That Swiss account had grown to $1.6 million. Peter called the bank every year or two to keep an eye on the account.

COMMENT:  I would too.

Fast forward to 2008, the year that UBS got in trouble with the (non)reporting on Swiss bank accounts. UBS notified the Horowitzes that they would be closing the account. Peter traveled to Switzerland and moved the funds to another bank. Susan travelled the next year to add her name to that account.

Peter opened a “numbered” account, which meant that a number rather than a name identified the account. He also requested the new bank to not send correspondence (termed “hold mail” - something the IRS did not like).

Why?

The bank explained:

… these services allowed U.S. citizens to eliminate the paper trail associated with undeclared assets and income they held … in Switzerland.”

This is going downhill.

In 2009 Peter started reading about IRS enforcement on foreign bank accounts. He and Susan decided to consult a tax attorney.

The Swiss account was now worth nearly $2 million.

They learned that they were supposed to – all along – have been reporting that account.

 In 2010 they closed the Swiss account, repatriated the funds and applied for a voluntary Treasury disclosure program.

Good idea.

They filed amended returns for the interest income, as well as filing FBARs disclosing the existence of the foreign account.

The interest income was not inconsequential: they sent the IRS more than $100 grand in back taxes.

Got it. It was going to hurt, so they might as well rip the band-aid.

In 2012 they opted out of the voluntary disclosure program (OVDP).

COMMENT:  The default ODVP penalty was 27.5%. I suspect - but do not know for certain - that they were hoping for a better penalty result during the audit process. Considering the Swiss account had neared $2 million, the penalty alone would have been around a half-million dollars.

In 2014 the IRS sent notices. The Horowitzes, their accountants and the IRS conferred but failed to reach an agreement.

The penalties now became an issue. The base FBAR penalty is $10 grand per instance. The IRS however saw the Horowitzes behavior as willful, meaning they wanted enhanced penalties. To muddy the waters further, the law had changed. What used to be a maximum $100 grand penalty was now the greater of $100 grand or 50% of the account.

COMMENT: You may also know the FBAR by its current name: FinCEN Form 114.

The Horowitzes protested. Their behavior was not willful, and - even if it was - the old penalty (maxed at $100 grand) should apply.

The Court was short on the willfulness issue.

The court acknowledged that the couple ‘insis[ed] that neither of them had actual knowledge on the FBAR requirement.’ But, relying on United States v. Williams …., it reasoned that willfulness in the civil context ‘covered not only knowing violations… but reckless ones as well’.”

In particular, the court pointed to the fact that the tax returns signed by the Horowitzes ‘included a question of whether they had foreign bank accounts, followed by a cross-reference’ to the FBAR filing requirement. It also found significant that, by their own account, the Horowitzes had ‘discussed their tax liabilities for their foreign accounts with their friends’ but failed to ‘have the same conversation with the accountants they entrusted with their taxes for years’.”

The Horowitzes appealed.

They argued that they messed up, but that mistake was not willful. The enhanced penalties should not apply.

The IRS countered: “willfulness” in this context includes recklessness, which standard was met by:    

The Horowitzes never asking their tax preparer whether they had to report the Swiss bank accounts,

The Horowitzes asking their friends about international tax matters demonstrated their awareness of potential issues,

The Horowitzes knew to report their Saudi earnings and U.S.-based interest income from domestic banks, and

The Horowitzes signed their tax returns without reviewing them with any care.

Here is the Court:

… their only explanation for not disclosing foreign interest income related to some unspecified conversations they had with friends in Saudi Arabia in the late 1980s. Yet, if the question of whether they had to pay taxes on foreign interest income was significant enough to discuss with their friends, they were reckless in failing to discuss the same question with their accountant at any point over the next 20 years.”

Taking all of these circumstances together, the record indisputably establishes not only that the Horowitzes ‘clearly ought to have known’ that they were failing to satisfy their obligation to disclose their Swiss accounts, but also that they were in a ‘position to find out for certain very easily’.”

How much are we talking about across the years?

Including interest and penalties, it was close to $1 million.

Our case this time was Horowitz v US, No. 19-1280 (4^th Cir. 2020)

A Lesser Known Statute Of Limitations

The last time I checked, IRS Appeals personnel count was down by approximately 20% and – no surprise – getting a case through Appeals is taking over a year.

There is danger – and potentially an immediate one – to taxpayers and tax advisors.

Take a look at this cheerful composition:

26 U.S. Code § 6532 - Periods of limitation on suits

(1) General rule

No suit or proceeding under section 7422(a) for the recovery of any internal revenue tax, penalty, or other sum, shall be begun before the expiration of 6 months from the date of filing the claim required under such section unless the Secretary renders a decision thereon within that time, nor after the expiration of 2 years from the date of mailing by certified mail or registered mail by the Secretary to the taxpayer of a notice of the disallowance of the part of the claim to which the suit or proceeding relates.

(2) Extension of time

The 2-year period prescribed in paragraph (1) shall be extended for such period as may be agreed upon in writing between the taxpayer and the Secretary.

(3) Waiver of notice of disallowance

If any person files a written waiver of the requirement that he be mailed a notice of disallowance, the 2-year period prescribed in paragraph (1) shall begin on the date such waiver is filed.

(4) Reconsideration after mailing of notice

Any consideration, reconsideration, or action by the Secretary with respect to such claim following the mailing of a notice by certified mail or registered mail of disallowance shall not operate to extend the period within which suit may be begun.

We see the following:

The IRS has 6 months to respond to a claim for refund. If no response is forthcoming within that time, the taxpayer can sue for refund, as long as the suit or proceeding occurs within the two-year period beginning with the date the IRS formally disallowed the claim.

What if the IRS never responds to the claim? Your tax advisor (CPA or attorney) will likely recommend you file suit within 2 years from filing the claim. If you file, a tax CPA will hand you off to a tax attorney. A tax CPA can do a lot, but one must be a member of the bar to litigate.

What happens if you miss the Section 6532 deadline?

Let’s look at this next artful arrangement:

26 U.S. Code § 6514 - Credits or refunds after period of limitation

(a) Credits or refunds after period of limitation

A refund of any portion of an internal revenue tax shall be considered erroneous and a credit of any such portion shall be considered void—

(1) Expiration of period for filing claim

If made after the expiration of the period of limitation for filing claim therefor, unless within such period claim was filed; or

(2) Disallowance of claim and expiration of period for filing suit

In the case of a claim filed within the proper time and disallowed by the Secretary, if the credit or refund was made after the expiration of the period of limitation for filing suit, unless within such period suit was begun by the taxpayer.

(3) Recovery of erroneous refunds

For procedure by the United States to recover erroneous refunds, see sections 6532(b) and 7405.

(b) Credit after period of limitation

Any credit against a liability in respect of any taxable year shall be void if any payment in respect of such liability would be considered an overpayment under section 6401(a).

Section 6514(a)(2) can be brutal: the IRS is prohibited from issuing the refund unless within such period suit was begun by the taxpayer.

Oh, this is all big corporate tax stuff, you say. Unless your name is Apple or Nvidia, can this ever reach you?

Yepper.

What if you filed for an ERC (employee retention credit) and (1) have never heard back from the IRS or (2) did hear back but the IRS disallowed the claim? The IRS has been using Letter 105C (if they disallowed the ERC claim in full) or Letter 106C (if they partially disallowed the claim). A 105C letter will include language like this:

         

There is the disallowance language that Sections 6532 and 6514 allude to.

When was the IRS sending out these letters?

After running ERC claims through a risk-scoring algorithm, the IRS sent out approximately 28,000 letters 105C and 106C during the summer of 2024. If the taxpayer responded (to the 105C or 106C), the IRS would then conduct an mini-audit before sending the file to Appeals.

2024 plus 2 years equals 2026 – your two-year statute of limitations is coming up.

Is there a way to avoid filing in Court but still preserve your rights to a refund?

Yes. Let’s go back to Section 6532(a)(2).

There is a form that goes with it.

  

Here is the Internal Revenue Manual on Form 907:

On first impression, I like the Form 907 option. What more do we need to know about it?

(1)  First, you are still within Section 6532, so this must be done within the 2-year window.

(2)  Both parties – you and the IRS – must sign Form 907.

(3)  If the case is being actively worked, the Revenue Agent or Appeals Officer can hopefully help obtain the appropriate IRS signature.

But what if the case is not being actively worked?

There are several ways this can happen:

·      The file is lost (I had one lost in IRS Kansas City a few years ago; it held up a real estate closing).

·      You are waiting for the protest to be transferred to Appeals.

·      The protest has been transferred to Appeals but remains unassigned.

·      The protest was transferred and assigned but your AO is no longer working at the IRS. It again is … unassigned.

·      You never even filed a protest to either Letter 105C or 106C.

The IRS considers Form 907 to be an internal form, to be initiated by IRS employees. If you have settled on Form 907 and your back is to the wall on obtaining an IRS signature, consider the Taxpayer Advocate.

But give yourself breathing room. I suspect that trying to obtain an IRS signature on short notice – whether actively worked or not, assigned or unassigned – will prove futile.

You might have to file suit to preserve the claim.